Friday, 30 September 2016

Ready To Take Action On Your Portfolio?

You’re a goalkeeper about to face a penalty kick. The speed the ball is likely to travel at means you must decide how to respond before it’s struck. More likely than not, you’ll choose to dive to your left or right.

That’s unfortunate. In an analysis of 286 penalty kicks taken in elite matches, it was found that keepers saved a third of penalties by standing still. This compared favourably to when they jumped to the left (14.2% saved) and to the right (12.6% saved)!

Goalkeepers shouldn’t beat themselves up. The need to do something is called action bias and it has a long history. Back in prehistoric times, this tendency served us well. It’s far better to run with the herd than risk being gobbled up by a predator. In the modern day however, this can be counterproductive. Nowhere is this more evident than with investing.

Why it’s so hard to stay still.

A great example of action bias was the aftermath of the EU referendum vote in the United Kingdom – or what’s commonly known as Brexit.

Back in June, a lot of people jettisoned excellent companies from their portfolios thanks to the uncertainty gripping the market. Like our ancestors, they sensed a threat, saw what others were doing and responded accordingly. So far, so human.

Unfortunately, this lost a lot of people a lot of money. Others, sensing a market overreaction, began hoovering up the shares and the markets rebounded. Even if the first group repurchased their shares (probably at a higher price), they still paid up in commission costs to do so.

This is one instance of the temptation to act. Investors also have to contend with the scarcity effect (“What if this is my last chance to buy cheap?”), boredom (“When will something happen to the share price?”) and the desire for quick returns (“Need bigger profits this month.”)

This doesn’t mean that acting is always a bad idea. Hindsight allows us to see that those with shorter investing horizons would have seen smaller losses in stocks such as Marco Polo Marine Ltd (SGX: 5LY) and Ezra Holdings Limited (SGX: 5DN) if they had sold sooner rather than later over the past three years.

Source: S&P Global Market Intelligence

The point is we need to distinguish sound investing decisions from the urge to do something, anything, with our investments.

Build a quiet room:

The first way of defending ourselves against action bias is to recognise our susceptibility to it. If you’re planning to make alterations to your portfolio, question your reasons for doing so. If this happens during times of market turmoil, recognise that standing still while others fret won’t kill you.

Next, focus on buying a diverse group of resilient companies with competitive advantages. They’ll have long histories of growing earnings and delivering high returns on capital employed (ROCE). If we set out to buy the right companies for a fair price, we reduce the need to act further down the line.

To further reduce this habit, we could also pay a little less attention to how the markets are behaving. If this makes us uncomfortable, we could sign up to news alerts from the companies we own. This way, we neatly avoid lots of irrelevant, panic-inducing noise, allowing us to make informed, stock-specific decisions.

French mathematician Blaise Pascal once reflected that a lot of our problems “derive from not being able to sit in a quiet room alone.” Know when to occupy yours.

Learning the identity of your greatest adversary is one of biggest challenges in investing. It’s not other private investors, day traders, or the big institutions. Rather, it’s likely to be the very person staring back at you in the mirror.

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